On 6 April, the US announced major sanctions against seven Russian oligarchs, the 12 Russian companies they control, and 17 Russian government officials in retaliation for Russia’s “malign activity”, including alleged involvement in the 2016 US election and interventions in Syria and Crimea. The move is designed to hurt those with close ties to the Kremlin and President Putin.
As a result Russian assets have repriced markedly, with additional risk premium now required by investors, although this is currently small compared to the 2014-15 Russia/Ukraine crisis. The fundamental outlook for Russian corporates is now less important than their ownership structure.
Chart 1: Russian credit spreads jumped after recent sanctions but are still well below levels reached during the Ukraine crisis of 2014/2015
Not like last time
Previous sanctions in 2014 targeted only a handful of issuers, forbidding them from issuing debt and equity. Most Russian banks and companies have been able to navigate this relatively easily and the sanctions had little impact on international investors. The sanctions announced on Friday 6 April mark a substantial escalation. The Department of the Treasury’s Office of Foreign Assets Control (OFAC) has banned US citizens and businesses from conducting any dealings with any of the named people or companies, or any company owned 50 per cent or more by a named individual. In addition, non-US citizens could face sanctions for continuing to deal with those on the OFAC list.
Sanctions are particularly strict against Rusal, the aluminium producer responsible for around 7 per cent of global production. US investors have been instructed to divest all Rusal debt and equity by 7 May, with international clearing agents unlikely to settle the company’s securities after this date.
Chart 2: Sanctions hit aluminium producer Rusal's share price
The news has introduced significant new uncertainty around Russian securities and which entities might be targeted by any further escalation of sanctions. For example, Sberbank, the largest bank in Russia, has a large credit line to Rusal ($4.5 billion as of H1 2017). While none of the sanctions directly affect Sberbank, it is unclear how the fallout might affect it; the sharp selloff in its shares since the news broke is a reflection of this uncertainty.
Secondary trading liquidity in Russian assets, especially the Russian corporate external debt market, reduced dramatically in the days following the announcement. Investors have flocked to traditional liquid hedging instruments such as the Russian ruble and Russian government credit default swaps to help protect underlying investments that they have struggled to reduce exposure to. In the near term, the dislocation of Russian assets will probably continue, but what does this mean for the future?
Why investors are worried
Investors have two reasons to be fearful:
- First, sanctions could broaden in scope in the future.
- Second, non-US citizens could fall foul of US law when dealing with Russian entities, potentially causing global sources of flows and trade into the Russian economy to dry up.
Additional sanctions that target larger systemic Russian companies such as Gazprom and Rosneft seem unlikely at this stage unless Russia escalates tensions in Ukraine or Syria. For investors, the greater danger might be to smaller Russian companies with owners associated with President Putin.
The fundamental outlook for Russian corporates is now less important than their ownership structure. Sulzer, a Swiss industrial engineering and manufacturing firm, announced over the weekend that it would buy back five million of its own shares from Viktor Vekselberg, an OFAC-named oligarch who currently owns 63 per cent of the company, to bring his stake below the 50 per cent threshold. Although this might have been expected to ease investors’ concerns, the company’s share price actually fell, indicating investors fear greater sanctions still, including lowering the 50 per cent ownership threshold.
The threat of a broader cessation of trade with Russia could be much more serious than additional US sanctions. But US investment (direct and portfolio) into Russia is very small, as are Russian exports to the US, relative to total trade flows and to Russia’s sizable current account surplus. And at this stage it does not look likely that the EU will join in with US sanctions, and it is unclear how hard the US will go after non-US citizens and companies who continue to do business with the affected parties.
Fundamentals unaffected… for now
Despite this dramatic re-evaluation of risk, the fundamental drivers of Russian securities remain largely unaffected and in many ways the country is well placed to weather the storm. Russia benefits from twin current account and fiscal surpluses, leaving it less vulnerable to external funding drying up. Russia’s new ‘fiscal stability’ rule provides domestic stability and makes the economy less pro-cyclical to oil prices. Recent negative shocks to the ruble may have been exacerbated by heavy consensus long positioning.
Chart 3: The ruble weakens against the dollar
Moreover, Russia has been building up foreign exchange reserves. This means that Russia’s central bank is in a solid place to intervene should it be necessary, something the authorities have already indicated is a possibility. Ruble interest rates and yields are well above those of hard currencies, both in real and nominal terms, so currency carry rates are sky-high, while domestic policy provides a great deal of stability. In a low-rates world, this leaves Russian debt looking attractive.
Stocks that are not on the sanctions list, including the big oil and gas stocks, are largely unaffected. Some investors who consider the probability of further sanctions to be low might be looking at certain recently revalued equities as potential bargains.
For most investors, however, adding exposure to Russian assets may still be premature. It is not clear how far the collateral damage from the recent sanctions will spread or if stronger sanctions might follow. Russian geopolitics remains fraught with danger and it is not easy to predict whether Russia will retaliate to the US administration’s latest measures.
Often markets initially overreact to such a news event and then gradually calm down but recent history shows us this is not always the case. In 2014, Russian credit default swaps widened by 20 basis points (bps) to 195bps a few days after the sanctions were announced, had moved to 300bps after a week and hit 600bps after several months. This may induce investors to adopt a wait-and-see attitude for the time being.
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